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What is an FHA ARM Loan?
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Backed by the Federal Housing Administration (FHA), an FHA ARM loan provides a lower interest rate and monthly payment for the first few years of the mortgage, before the initial fixed rate converts to an adjustable rate mortgage (ARM). This could make moving into home ownership more affordable and provide upfront savings for many borrowers.
How does an FHA ARM loan work?
With an FHA ARM loan, the mortgage starts with an initial fixed interest rate and monthly payment for a set period of time. “After the initial low-rate period, which may range from one to 10 years, depending on the loan product, the rate may move up or down based on market rates and loan terms,” says Andrina Valdes, chief operating officer of Cornerstone Home Lending, Inc. in San Antonio. Depending on the loan, those rate changes could take place once or even twice every year for the remainder of the loan. Any rate change could also change your monthly payment.
When opting for an ARM loan, borrowers may be able to qualify for a more expensive home as a result of the initial low rate and monthly payment. However, because that rate could increase once the initial fixed period is over, continuing to make a higher monthly payment may become more difficult over time.
FHA ARM loan requirements
As with all mortgage loans, you will need to go through the process of applying and qualifying for an FHA ARM loan. This ranges from getting your finances in order to finding the right lender and making sure you meet any loan requirements.
Review your credit history. To improve your chances of qualifying for a FHA ARM loan, you need to make sure your finances are in the best shape possible. This includes reviewing your credit history with all three credit reporting agencies to make sure your credit report is correct. This will help ensure your credit score meets the FHA requirements. Although credit score requirements vary by lender, the FHA does guarantee loans if your credit score is as low as 500.
Save for your down payment. The more you put down on your FHA ARM loan, the more favorable you appear to your lender. “With an FHA loan, the down payment requirement may be as low as 3.5%, with as low as a minimum 580 credit score, in some cases,” Valdes says.
Pay down debt before applying. Lenders will look at your debt-to-income (DTI) ratio to see if you can afford to pay your mortgage. They determine your DTI ratio by adding up your monthly debt payments and dividing it by your gross monthly income. “This loan can only be used for primary residences with a DTI threshold of up to 50%, in some cases,” Valdes says.
Shop around for a lender who specializes in FHA ARMs. It’s important to find a lender who has experience with adjustable rate mortgages (ARMs), including an FHA ARM loan. Speak with at least three lenders, and provide them with the same information to get a rate quote and information on fees. Make sure the loan terms are the same so it’s a fair and equitable comparison.
Pros and cons of an FHA ARM loan
As with all loans, not every loan is right for every borrower. It’s important to consider the pros and cons of an FHA ARM loan to determine if this mortgage meets your financial needs.
You can take advantage of low rates. Locking in a low interest rate for the initial term of the loan could help you afford a more expensive home than you otherwise would qualify for with a higher rate. This lower rate could mean a lower monthly payment, allowing you to save for later when the interest rate starts to fluctuate.
You could have a more affordable down payment. With an FHA ARM loan, you may be able to qualify with a down payment as low as 3.5% if you have a minimum credit score of 580.
You could qualify with a less-than-stellar credit score. Individual lenders will set their own requirements for minimum credit scores, but the FHA will guarantee loans with a minimum credit score of 500. However, that could mean you may have to pay a higher down payment.
You could qualify even if you’re a first-time homebuyer. You don’t have to be an experienced or previous homebuyer to receive an FHA ARM loan. “The candidate for an FHA ARM loan is typically a first-time homebuyer with a low to mid income,” Valdes says. “If you’re a first-time buyer who may not plan to stay in your home for long but still wants to start building equity, this loan could be ideal.”
You are protected from excessive rate increases. Although the interest rate will increase once the initial fixed-rate period ends, an FHA ARM loan rate can increase no more than 1% to 2% each year. It also cannot increase more than 5% to 6% for the life of the mortgage loan.
You could pay a higher monthly payment. Because the rate will fluctuate after the fixed-rate period ends, it could go up, meaning your monthly payment also could increase, making it no longer affordable for you.
You have to pay for mortgage insurance. When you receive an FHA ARM loan, you will incur a 1.75% fee to insure the loan. During the loan term, you’ll have to pay a mortgage insurance premium (MIP). If your down payment is less than 10%, you’ll pay for MIP for the entire loan term, but if you pay at least 10% down, you’ll stop paying MIP after 11 years.
You may not qualify for the amount you need. FHA ARM loan limits are typically less than those of a conventional mortgage, which means they could be too low to cover the cost of a home where you live.
Should you get an FHA ARM loan?
An FHA ARM loan is not right for every borrower, so it’s important to evaluate your financial needs and future to determine if an arm loan is the best option for you. You also need to evaluate the terms and fees of an FHA ARM loan to make sure you fully understand them.
You don’t plan to keep the home very long
If you know you’ll be moving soon, you could take advantage of an FHA ARM loan’s initial low rate. “If you think you’ll relocate in a few years’ time, you could come out on top with an ARM by selling before the rate starts to fluctuate,” Valdes says.
You want to pay off your mortgage early
Because you will have a fixed lower rate at the beginning of your FHA ARM loan term, you could pay additional amounts on your principal that would not only help you pay off your mortgage sooner, but also save thousands of dollars in interest.
You can pay for the loan even if the rate increases
It’s important to understand just how much your FHA ARM loan will cost over the term of the mortgage. Ask your lender what the maximum monthly loan payment could be for your loan. If you could afford it, an FHA ARM loan could be right for you.
You could buy a home while rebuilding your credit
Because you could qualify for a FHA ARM loan with a lower credit score, you could go ahead and buy a house now instead of waiting while you rebuild your credit.
You are expecting a pay raise
If you see a raise in your near future, getting an FHA ARM loan could be a good fit because you’ll be able to afford the monthly payments now and later when the interest rate may increase.